Relevant to ACCA Qualification Paper P7
Making estimates is an inevitable part of preparing financial statements. Management will need to make estimates about many of the assets and some of the liabilities in order to show them at a reliable value. These estimates will include some routine matters such as the expected life of property, plant and equipment, estimating appropriate allowances for receivables and some more challenging matters, such as valuation of pension liabilities for a newly acquired subsidiary. Estimates share one characteristic above all others – they are an attempt to look into the future and are consequently subject to a high degree of uncertainty and so inherent risk of misstatement.
ISA 700 requires that an auditor expresses an opinion in terms of reasonable assurance. This requires us to state an opinion that we believe a set of financial statements present a true and fair view (or are fairly presented). The assertive nature of this opinion requires a substantial amount of robust evidence to support it. It is rather too easy to drop into auditing estimates to a degree where conclusions become that management’s estimates are ‘reasonable’ or even ‘plausible’. Neither of these conclusions mirror the wording used in our actual audit report and so are insufficient to comply with the requirement of ISA 700 and ISA 540, Auditing Accounting Estimates, Including Fair Value Accounting Estimates, and Related Disclosures. Obtaining certainty about the future is impossible, but obtaining evidence to support a reasonable conclusion on likely future outcomes is not.
It is logically impossible to say that an estimate about the future is certain to be right. It’s much easier, however, to identify when an estimate is likely to be wrong. So it is perhaps easiest to start off identifying some common situations when an estimate looks likely to be materially misstated. This list isn’t exhaustive, but it includes some of the biggest potential errors and you should be sure that you’re comfortable with all of them before taking the Paper P7 exam.
Misunderstanding the stated system of GAAP. In the audit report, we define true and fair, or fair presentation, by referring to full compliance with a stated system of GAAP. It is, therefore, essential to have an in-depth knowledge of the GAAP system being used to define truth and fairness before it’s possible to express an audit opinion that is built on that system. This is why you can expect a reasonable amount of accounting knowledge to be needed to pass Paper P7.
Unfortunately, there is not one unifying method of deciding what constitutes a true and fair estimate. For example, inventory will be defined as being fairly estimated in value if it is valued at the lower of cost and net realisable value. Contingent liabilities are fairly estimated if they are shown with a value of zero, unless they are being valued as part of an acquirer’s initial consolidation of a new subsidiary (see later). The definition of fair value given in the IASB glossary is: The amount for which an asset could be exchanged, or a liability settled, between knowledgeable, willing parties in an arm’s length transaction. In practice, this definition is stretched somewhat depending on the asset or liability in question and so it is necessary to know the specific rules for each material asset or liability.
Management bias. Bias is not necessarily deliberate, but is almost certain to exist in most estimates. Bias may be exacerbated during a takeover situation, when management are likely to wish to convince sellers of a business that net assets have a lower fair value than they really have, in order to obtain a lower price for the acquired business. Innate optimism and human nature may deter management from wishing to accept that less will be received from receivables than management wish. Familiarity with preparing estimates in an established way may also build in long-standing bias.
Poor data, poor controls. If information systems are poor, even neutral management will produce estimates that are unreliable. For example, if a loan provider has poor data collection on overdue repayments, estimates of impairments of financial assets are likely to be unreliable.
When a parent company acquires a new subsidiary, it will pay the fair value of the acquired company as a whole. This is because the previous owners tend to be unwilling to sell their company for less than its fair value. In order to bring in a fair estimate of the initial value of goodwill, IFRS 3, Business Combinations requires that the individual net assets of the acquired company be valued at their fair value at the date of the acquisition. Fair value still means the amount that would be transferred between knowledgeable parties in an arm’s length transaction. Often, the acquirer will have investigated their assessment of value of material assets, liabilities and contingent liabilities of the target company as part of a pre-acquisition due diligence investigation. In these circumstances, the values ascribed to individual assets and liabilities in this due diligence will be an appropriate value to use for the initial recognition of each asset and liability. This means that fair value often becomes fair value through the eyes of the acquirer. This is not always the most appropriate valuation basis, however, since the value given by the acquirer may include some degree of the acquirer’s intentions. For example, it is common for a new acquirer to plan to restructure an acquired business shortly after the acquisition. This might include an intention to pay off any litigation in progress at the date of acquisition in order to fee management time for integration of the subsidiary into its new group. This could result in incorrect recognition of provisions that are higher than the true value of the obligation.
IAS 37, Provisions, Contingent Liabilities and Contingent Assets normally prohibits recognition of contingent liabilities. This rule is overturned on the acquisition of a new subsidiary, since the existence of contingent liabilities (eg individual lawsuits against the company) will reduce the value that the acquirer is willing to pay for control of the company. To ensure a fair value of initial goodwill, contingent liabilities must be valued within the statement of financial position; with the most appropriate valuation probably being the amount that the acquirer would be willing to pay an independent third party to assume the risk on their behalf.
IFRS 3 also requires recognition of any contingent consideration payable to the sellers of the new subsidiary. These are common in ‘earn out’ arrangements where the amount that the seller eventually pays is adjusted for post-acquisition profit of the business. The determination of a fair value of this contingent consideration is subject to elevated estimation uncertainty.
ISA 540 states that the auditor’s objective is to obtain sufficient, appropriate evidence on whether:
A critical first step for the auditor in planning the work needed on estimates is to understand the client’s business and identify where the greatest scope for accidental or deliberate bias in production of estimates exists. This assessment will include a formal and documented assessment of:
Historically, estimates have arguably mostly been audited by assessing the client’s schedules and determining if they are reasonable. ISA 540 requires a more forensic approach than this.
The greater the potential materiality of an item and the greater its estimation uncertainty, the greater the evidence will need to be in order to be sufficient and appropriate to base a conclusion. The core evidence is likely to be:
Audit of estimates is subject to a high degree of uncertainty. The degree of audit risk is somewhat reduced by GAAP systems accepting that more than one estimate of the same uncertainty may give a true and fair view. This is why GAAP systems often require substantial disclosure of the circumstances giving rise to the uncertainty; so that readers can make up their own mind.
Audit of estimates is likely to be a common feature in the Paper P7 exam, as well as in practice. Auditor’s judgment is often difficult to challenge. Failure to follow the prescribed steps that lead to the use of auditor’s judgment however is much easier to attack in any negligence action. Both Paper P7 students and auditors in practice will do well to be familiar with the enhanced requirements of ISA 540.
Graham Fairclough is group technical director at the ExP Group